Implications of Federal Partnership Audit Rules for State and Local Taxation
The new federal partnership income tax audit rules, scheduled to take effect on January 1, 2018, will have significant implications for the state and local taxation of partnerships and their partners. Most, but not all, states that impose a net income-based tax adopt by reference the federal definition of taxable income, but those that do typically adjust that income to reflect differences between state and federal tax policies. Moreover, state revenue departments generally do not regard themselves as being bound by Internal Revenue Service interpretations of the Internal Revenue Code even when substantive Code provisions are incorporated into state law by reference. The federal statutory rules relating to partnership audits are procedural rules and not ones of substantive tax law, so they will not be automatically adopted by states that generally conform to Internal Revenue Code provisions relating to taxable income. State legislatures may decide to adopt some or all of the federal statutory rules, or they may decide to adopt none of them. Arizona has already adopted its own version of the federal rules, and other state revenue departments are considering recommending to their legislatures that the legislatures take similar action, but most states have not reacted to the federal rules at this time.
Most states follow the federal regime under which partnerships are treated as flow-through entities and their income is taxed directly to the partners, but not all do and some states impose an entity-level tax on partnerships’ net income. States that do not impose an entity-level tax on partnerships will have to decide whether to make an exception to the extent that the new federal rules require tax deficiencies to be paid by the partnership. Many states require partnerships to withhold tax on the distributive shares of income of nonresident partners. Differences in tax regimes may result in differences in tax administration procedures, even if state revenue departments and state legislatures conclude that conformity to the federal procedures will generally be desirable. A practical problem that will confront partnerships that are doing business in a number of states is that the different states may have different procedures for handling partnership audits.
Some issues that often arise in connection with state taxation do not occur in connection with federal taxation, and the states will have to decide whether special procedures should be adopted to address them, even if they generally conform to the federal procedures. These include the apportionment of income of a multistate enterprise, the treatment of special state credits and other incentives, and questions of taxable nexus. As to the apportionment of income, the partnerships will often not know the extent to which the partners are taxed on the partnerships’ income. In many cases, that will depend on the extent to which the partner’s income is apportioned among the different states in which the partner does business, and this will depend, in turn, on the extent to which its property, payroll and sales are attributable to different states, information to which the partnership often will not have access. As a result of issues like this, states may conclude that adopting the federal rules or a variation of them would be impractical.
The federal rules require the partnership to designate a partnership representative to handle discussions with the Internal Revenue Service. The representative need not be a partner. The states will have to decide whether the person who is selected as the partnership representative for federal tax purposes should also be the representative for that state’s tax purposes. A person who is experienced in dealing with the Internal Revenue Service and who is familiar with federal tax issues may not be knowledgeable or experienced with respect to state tax issues or with respect to dealing with the revenue department of a particular state. One would hope that the states will allow a partnership to select a person other than the federal representative to be the partnership’s representative for partnership audit purposes.
The states generally require taxpayers to report federal changes to the state department of revenue so that the department has the opportunity to consider whether those changes should result in additional state tax. The states would have to consider whether, and how, to require reports to be made with respect to partnership-level adjustments under the federal regime. The states typically extend the statute of limitations on assessing deficiencies to give the revenue department an opportunity to audit state changes resulting from the federal adjustments.
Companies that do business in more than one state must apportion their income among the different states. Under the Commerce Clause of the United States Constitution (typically reflected in state law), each state can tax only the income that is attributable to activities conducted in that state. The factors that are considered in attributing income among the states typically include the locations of the company’s property, payroll and sales. Each state has its own apportionment formula and the formulas of the states are not consistent. Each state will have to decide whether to use the partnership’s apportionment factors in determining the extent to which an entity-level tax will be imposed on the partnership corresponding to the federal tax.
The federal regime allows a partnership with 100 or fewer eligible partners to elect out of the partnership audit procedures. The states will have to decide whether to permit a similar election for state tax purposes. The states might want to adopt special rules relating to the election. For example, a state might adjust the number upwards or downward from 100. It might also apply the test only to partners that are resident in or have nexus with the state, although in such case the partnership might not have access to that kind of information about its partners. Another approach would be to provide that a federal election out would automatically apply to the state regardless of the number of partners that are taxable by the state.
The states will have to decide when other partnership elections are made, such as the election to push out liabilities to partners.
States that conform to the federal definition of taxable income typically require taxpayers to report changes resulting from Internal Revenue Service audits or refund claims to the state revenue department within a certain period of time. It would be desirable for the states to adopt a uniform approach to the timing of these reports and the filing of refund claims; otherwise, partnerships will be subject to significant administrative burdens in meeting different state filing requirements. Moreover, if a federal change results in changes in a partnership’s apportionment factors (i.e., the calculation of its property, payroll and sales), these could change the apportionment factors of a partner in every state in which the partner files returns, thus resulting in significant administrative burdens.
Partnerships will have to make decisions as to how to treat nonresident partners. There has been a significant amount of litigation involving the question of whether a nonresident limited partner or limited liability company member can constitutionally be taxed by a state on his or her share of partnership income that is attributed to that state. The courts have divided on the subject and some courts have held that such partners cannot be taxed on such income. It would seem clear that a nonresident partner cannot be compelled to file returns in a state where the courts of that state have held that he or she cannot be taxed. On the other hand, presumably a partnership as a matter of partnership law could pay that person’s share of the partnership-level tax and charge it to the partner’s capital account. Resolving these issues will involve sensitive questions of relationships among partners and appropriate provisions will have to be added to partnership agreements.
The new federal partnership audit regime presents significant issues to state legislatures and revenue departments as well as to partnerships and their partners. While some state revenue departments and legislative staff have begun to address these issues, only one state, Arizona, has adopted legislation at this point. The states are likely to adopt different approaches to many of these issues with the result that partnerships and their partners will be faced with many complex and conflicting rules